A RANDOM COEFFICIENT

AUTOREGRESSIVE MARKOV
REGIME SWITCHING
MODEL FOR DYNAMIC
FUTURES HEDGING
HSIANG-TAI LEE
JONATHAN K. YODER*
RON C. MITTELHAMMER
JILL J. MCCLUSKEY

The random coefficient autoregressive Markov regime switching model

(RCARRS) for estimating optimal hedge ratios, which generalizes the ran-
dom coefficient autoregressive (RCAR) and Markov regime switching
(MRS) models, is introduced. RCARRS, RCAR, MRS, BEKK-GARCH,
CC-GARCH, and OLS are compared with the use of aluminum and lead
futures data. RCARRS outperforms all models out-of-sample for lead and

*Correspondence author, School of Economic Sciences, Washington State University, P.O. Box
646210 Pullman, WA 99164-6210; e-mail: yoder@wsu.edu

Received December 2004; Accepted May 2005

■ Hsiang-Tai Lee is an Assistant Professor in the Department of Banking and Finance at

National Chi Nan University in Taiwan.
■ Jonathan K. Yoder is an Assistant Professor in the School of Economic Sciences at
Washington State University in Pullman, Washington.
■ Ron C. Mittelhammer is a Regents Professor in the School of Economic Sciences at
Washington State University in Pullman, Washington.
■ Jill J. McCluskey is an Associate Professor in the School of Economic Sciences at
Washington State University in Pullman, Washington.

The Journal of Futures Markets, Vol. 26, No. 2, 103–129 (2006)

© 2006 Wiley Periodicals, Inc.
Published online in Wiley InterScience (www.interscience.wiley.com).
DOI: 10.1002/fut.20193
104 Lee, Yoder, Mittelhammer, and McCluskey

is second only to BEKK-GARCH for aluminum in terms of variance-

reduction point estimates. White’s data-snooping reality check null
hypothesis of no superiority is rejected for BEKK-GARCH and RCARRS
for aluminum, but not for lead. © 2006 Wiley Periodicals, Inc. Jrl Fut
Mark 26:103–129, 2006

INTRODUCTION
If the optimal hedge ratio is constant over time, its value can be estimated
as the parameter of a simple linear regression of historical spot returns
on futures returns. The slope coefficient on futures returns is the esti-
mated optimal hedge ratio, and is equal to the covariance between the
spot and futures returns divided by the variance of the futures return
(Ederington, 1979; Figlewki, 1984; Chen, Lee, & Shrestha, 2003).
There are two problems with this conventional regression approach to
optimal hedge ratio estimation. First, it uses unconditional sample
moments instead of conditional ones and, as a consequence, fails to take
proper account of currently available information. Second, the assump-
tion that these second moments, and hence the optimal hedge ratio, are
constant over time ignores the fact that many asset prices may follow
time-varying distributions. To improve hedging performance, this time-
varying property should be accounted for (Myers, 1991; Myers &
Thompson, 1989).
Two general approaches have been developed to estimate the time-
varying hedge ratio. One approach is to estimate the hedge ratio by esti-
mating the conditional second moments via one of a variety of GARCH
(generalized autoregressive conditional heteroscedasticity) models pro-
posed by Engle (1982), Engle and Kroner (1995), and Bollerslev (1986,
1990). Baillie and Myers (1991) study commodity futures contracts and
estimate optimal hedge ratios by using a bivariate GARCH model with
diagonal vech parametrization. Kroner and Sultan (1993) study foreign-
currency futures, and Park and Switzer (1995) study stock index futures
with a bivariate constant-correlation GARCH (CC-GARCH) model.
Gagnon and Lypny (1995) use a GARCH model with the BEKK (Baba-
Engle-Kraft-Kroner) parametrization to study interest-rate futures.
Kavussanos and Nomikos (2000) introduce an augmented GARCH
model to investigate hedging effectiveness in the freight futures market.
Byström (2003) applies orthogonal GARCH and CC-GARCH to study
the hedging performance in the electricity futures market.
The other general approach treats the hedge ratio as a time-
varying coefficient and estimates the coefficient directly instead of

Journal of Futures Markets DOI: 10.1002/fut

 Dynamic Futures Hedging 105

estimating the second moments. Bera, Garcia, and Roh (1997)

estimate optimal hedge ratios for corn and soybeans with a random
coefficient autoregressive model (RCAR). Alizadeh and Nomikos
(2004) introduce the Markov regime switching (MRS) model for esti-
mating the time-varying minimum-variance hedge ratio for stock index
futures. This model allows the hedge ratio to be dependent upon the
state of market volatility, and the hedge ratio is time varying in the
sense that the transition probabilities are a time-varying function of
the lagged basis.
This article proposes the random coefficient autoregressive regime
switching (RCARRS) model, which combines properties of both RCAR
and MRS. RCARRS is different from MRS in a number of ways. First,
RCARRS models the equilibrium time path of the hedge ratio and also
allows the hedge ratio to be dependent upon the state of the market.
Second, the hedge ratio estimated from RCARRS is time varying even
when the transition probabilities are constant. The hedge ratio estimated
from MRS is time varying in the sense that the transition probabilities are
a time-varying function of the lagged basis.1 With constant transition
probabilities, the hedge ratio estimated from MRS is time invariant.
Third, there is no upper and lower bound on the time-varying hedge ratio
in the RCARRS model. The hedge ratio estimated from RCARRS can
fluctuate freely. The hedge ratio estimated from MRS, however, restricts
the hedge ratio to a given range. To implement the model, Kim’s filter
(Kim, 1994; Kim & Nelson, 1999) is applied, along with a transformation
of the latent hedge ratio to allow a state-space representation (Hamilton,
1994).2
The performance of the present model is compared with OLS,
RCAR, MRS, CC-GARCH, and BEKK-GARCH models, all of which are
applied to aluminum and lead futures contracts traded on the London
Metal Exchange. Performance comparisons are based on point estimates
of the percentage variance reduction of the hedging portfolio with the
use of either in-sample data (data used to estimate model parameters), or
out-of-sample data (additional data in the series subsequent to the
sample used to generate parameter estimates). To test the statistical

1
Because transition probabilities are constant in RCARRS but time-varying in MRS, MRS is not
nested within RCARRS. However, RCARRS still possesses both Markov regime switching and
random coefficient autoregressive properties.
2
The state-space model with Markov regime switching proposed by Kim extends Hamilton’s (1989)
Markov-switching model to the state-space representation of the general dynamic linear model. Kim
applies his model to investigate the link between inflation and its uncertainty over long and short
horizons (Kim, 1993a), and examines the effects of different sources of monetary growth uncertainty
on economic activity measured by real GNP (Kim, 1993b).

Journal of Futures Markets DOI: 10.1002/fut

106 Lee, Yoder, Mittelhammer, and McCluskey

significance of the variance reductions, White’s reality check is per-

formed for data snooping on the out-of-sample data (White, 2000).3 To
implement the test, the poorest-performing model for each data set is
used as the benchmark for that data set.
The article proceeds from here as follows. In the next section, the
RCAR and MRS models are introduced. The RCARRS model and its
estimation procedure are presented (GARCH models used in this article
for comparison are summarized in the Appendix). Hedging-performance
criteria, including hedging portfolio variance reduction, a common
expected utility measure, and White’s data-snooping reality check test
are discussed. Data descriptions and empirical results are reported and
discussed, and a conclusion is provided.

RANDOM COEFFICIENT AUTOREGRESSIVE

(RCAR) AND MARKOV REGIME SWITCHING
(MRS) MODELS
If one assumes that the minimum-variance hedge ratio is constant, it can
be estimated with the regression model
Rs,t ⫽ a ⫹ bRf,t ⫹ et (1)
where Rs,t and Rf,t are the spot and futures returns for period t, respec-
tively, and the et’s are independent and identically distributed (iid) ran-
dom disturbances with mean zero and variance se2. The estimate of the
minimum-variance hedge ratio, b*, is the estimated slope coefficient,
Côv(Rs, Rf )
b̂* ⫽ (2)
Vâr(Rf )
To allow the hedge ratio to be time varying, Bera et al. (1997) model
the hedge ratio with a random coefficient autoregressive (RCAR)
process, which can be written as
Rs,t ⫽ a ⫹ btRf,t ⫹ et
(3)
(bt ⫺ b) ⫽ f(bt⫺1 ⫺ b) ⫹ nt
where bt is a time-varying coefficient, b is the steady-state value of
b, 0f 0 ⬍ 1, and et and nt are independent and identically distributed
random variables with mean zero and variances s2e and s2n , respectively.4

3
An anonymous reviewer suggested the use of White’s reality check for a statistical comparison of
the models examined.
4
The unknown parameters a, b, f, se2, and sn2 and in Equation (3) can be estimated via maximum-
likelihood estimation. The log-likelihood function and estimation procedure are presented in
Hamilton’s time-series analysis (1994).

Journal of Futures Markets DOI: 10.1002/fut

 Dynamic Futures Hedging 107

Although the RCAR model characterizes the equilibrium time path of the
hedge ratio, it fails to condition the hedge ratio on the state of market
volatility.
To account for the state of market volatility, Alizadeh and Nomikos
(2004) study the FTSE-100 and S&P 500 stock index futures market by
modeling the hedge ratio with a Markov regime switching (MRS)
process. The rationale behind this model is that the dynamic relationship
between spot and futures returns may be characterized by regime shifts
in the spot-futures relationship that may have an impact on the hedge
ratio and therefore on hedging effectiveness. To allow for regime shifts,
Equation (1) is extended to a two-state, first-order Markov regime
switching model written as

Rs,t ⫽ ast ⫹ bstRf,t ⫹ et,st (4)

where et,st ⬃ iid(0, s2st) and st ⫽ 1, 2 indicates the market regime at time
t. Limiting the number of the regimes to two improves the model’s
tractability and, intuitively, a two-state process corresponds to periods of
high- and low-volatility in the markets. The hedge ratio in this model is
time varying in the sense that the transition probabilities depend on the
average lagged basis, which is time varying. The transition probabilities
are denoted as

P(st ⫽ 1| st⫺1 ⫽ 2) ⫽ P21, P(st ⫽ 2| st⫺1 ⫽ 2) ⫽ P22 ⫽ 1 ⫺ P21

(5)
P(st ⫽ 2| st⫺1 ⫽ 1) ⫽ P12, P(st ⫽ 1| st⫺1 ⫽ 1) ⫽ P11 ⫽ 1 ⫺ P12

Utilizing the logistic function to model the probabilities ensures

that the estimated probabilities are constrained to the (0, 1) interval, as

1 1
P12,t ⫽ , P21,t ⫽ (6)
1 ⫹ exp(f0,1 ⫹ f1,1 ABt⫺1 ) 1 ⫹ exp(f0,2 ⫹ f1,2 ABt⫺1 )

3
where ABt ⫽ (g i⫽0 Basist⫺i )兾4 represents the average basis over the
most recent 4 weeks.
Equation (4) yields two estimated hedge ratios b̂1 and b̂2, which are
the estimated minimum-variance hedge ratios given the state of the mar-
ket and also represent the upper and lower bounds of the estimated
time-varying optimal hedge ratio b̂*t , which is the expectation of the two
hedge ratios:
b̂*t ⫽ p1,t b̂1 ⫹ p2,t b̂2 (7)

Journal of Futures Markets DOI: 10.1002/fut

108 Lee, Yoder, Mittelhammer, and McCluskey

The parameters p1,t and p2,t are regime probabilities for States 1
and 2 at time t conditional on the state of the market at t ⫺ 1:
1 ⫺ P22,t
p1,t ⫽ P(st ⫽ 1) ⫽
2 ⫺ P11,t ⫺ P22,t
(8)
1 ⫺ P11,t
p2,t ⫽ P(st ⫽ 2) ⫽
2 ⫺ P11,t ⫺ P22,t
The unknown system parameters ast, bst, s2st, f0,st, and f1,st can be
estimated by maximizing the following log-likelihood function with
respect to the unknown parameters:
T p1,t ⫺(Rs,t ⫺ a1 ⫺ b1Rf,t ) 2
LL ⫽ a log e exp c d
t⫽1 22ps21 2s21

p2,t ⫺(Rs,t ⫺ a2 ⫺ b2Rf,t ) 2

⫹ exp c df (9)
22ps22 2s22
where T is the total number of observations, p1,t and p2,t are functions of
f0,st, f1,st, and ABt, according to Equations (5), (6), and (8), and the like-
lihood function itself is derived from the mixture of the respective regime
probability distributions.
The Markov regime switching model conditions the hedge ratio on
the state of market volatility. However, it fails to characterize the equilib-
rium time path of the time-varying hedge ratio.

RANDOM COEFFICIENT AUTOREGRESSIVE

REGIME SWITCHING (RCARRS) MODEL
The RCARRS model possesses properties of both the RCAR and MRS
models. As pointed out by Kim (1993b), there are two types of uncer-
tainty within a regression context: uncertainty that arises because of het-
eroskedasticity in the disturbance term, and uncertainty that arises as
economics agents are obliged to infer the unknown or changing regres-
sion coefficients. As noted earlier, the RCAR model fails to condition the
hedge ratio on the state of market volatility, and the MRS model fails to
characterize the equilibrium time path of the hedge ratio. The RCARRS
method accounts for both of these sources of uncertainty. It allows the
hedge ratios to follow a random coefficient autoregressive process and
also to be affected by the state of the market. The model is specified as
Rs,t ⫽ ast ⫹ btRf,t ⫹ et,st (10.1)
(bt ⫺ b) ⫽ f(bt⫺1 ⫺ b) ⫹ nt (10.2)

Journal of Futures Markets DOI: 10.1002/fut

 Dynamic Futures Hedging 109

where et,st ⬃ iid(0, s2e,st ) and nt ∼iid(0, sn2). In comparison to the RCAR
model of Equation (3), Equation (10.1) includes state-specific versions of
a and et. The unobserved state variable st follows a two-state, first-order
Markov-switching process, with the following transition probabilities:

P(st ⫽ 2 0 st⫺1 ⫽ 2) ⫽ p ⫽
exp(p0 )
1 ⫹ exp(p0 )
(11)
P(st ⫽ 1 0 st⫺1 ⫽ 1) ⫽ q ⫽
exp(q0 )
1 ⫹ exp(q0 )

where p0 and q0 are unconstrained parameters that can be estimated along

with unknown system parameters via maximum-likelihood estimation.
RCARRS can be estimated with Kim’s filter (Kim, 1994), but because
the present model is not in a standard state space form, it needs to be
transformed to apply Kim’s filter (Hamilton, 1994). The procedure for
estimating the RCARRS model is summarized in Table I and is discussed
in detail below.
To convert RCARRS into a standard state space form, replace the
latent variable bt with dt ⫽ bt ⫺ b, and rewrite Equations (10.1) and
(10.2) as

Rs,t ⫽ (ast ⫹ bRf,t ) ⫹ dtRf,t ⫹ et,st (12.1)

dt ⫽ fdt⫺1 ⫹ nt (12.2)

TABLE I
Summary of the RCARRS Estimation Procedure

RCARRS model Rs,t ⫽ ast ⫹ btRf,t ⫹ et,st

(bt ⫺ b) ⫽ f(bt⫺1 ⫺ b) ⫹ nt
Rs,t ⫽ (ast ⫹ bRf,t ) ⫹ dtRf,t ⫹ et,st
Replace bt with dt ⫽ fdt⫺1 ⫹ nt
dt ⫽ bt ⫺ b
Run Kim’s Filter to extract dtj 1. Run Kalman filter
2. Run Hamilton filter
3. Approximation
Parameter estimation Maximizing the log likelihood function in equation (18) with
respect to the unknown parameters
2
(p0, q0, ast, se,s t
, sn2, b, f)

Recover btj b̂ tj 0 t ⫽ d̂ tj 0 t ⫹ bˆ, j ⫽ 1, 2

Estimates of hedge ratios b̂*t 0 t ⫽ b̂1t 0 t P(st ⫽ 1 0 ct ) ⫹ b̂t20 t P(st ⫽ 2 0 ct )
One-step-ahead forecast of b̂*t 0 t⫺1 ⫽ b̂1t 0 t⫺1P(st⫺1 ⫽ 1 0 ct⫺1 ) ⫹ b̂ t20 t⫺1 P(st⫺1 ⫽ 2 0 ct⫺1 )
hedge ratios

Journal of Futures Markets DOI: 10.1002/fut

110 Lee, Yoder, Mittelhammer, and McCluskey

After transformation, Equations (12.1) and (12.2) are in a standard

state space form and can be estimated with Kim’s filter. Kim’s filter can be
interpreted as a combination of extended versions of the Kalman filter and
the Hamilton filter, along with appropriate approximations. It contains the
following steps. First, run the Kalman filter given in Equations (13.1)–(13.6)
for prediction equations:
i
d̂t|t⫺1 ⫽ fd̂t⫺1|t⫺1
i
(13.1)

Mti 0 t⫺1 ⫽ f2Mt⫺1

i
0 t⫺1 ⫹ sn
2
(13.2)
updating equations:

0 t⫺1 ⫽ Rs,t ⫺ aj ⫺ bRf,t ⫺ d̂t 0 t⫺1Rf,t

ht(i,j) i
(13.3)

0 t⫺1 ⫽ Rf,tMt 0 t⫺1 ⫹ se, j

ft(i,j) 2 i 2
(13.4)
(i,j) ⫺1 (i,j)
0 t ⫽ d̂t0 t⫺1 ⫹ Mt 0 t⫺1Rf,t ( ft 0 t⫺1 ) ht 0 t⫺1
d̂t(i,j) i i
(13.5)
(i,j) ⫺1
0 t ⫽ [1 ⫺ Mt 0 t⫺1Rf,t ( ft|t⫺1 ) ]Mt 0 t⫺1
Mt(i,j) i 2 i
(13.6)
i i
where d̂t⫺1 0 t⫺1 is the estimate of dt⫺1 and d̂t 0 t⫺1 is a prior estimate of dt
based on information up to time t ⫺ 1, given st⫺1 ⫽ i. Mt|t⫺1 i
is the error
i (i,j)
covariance matrix of dt 0 t⫺1. ht 0 t⫺1 is the conditional forecast error of Rs,t,
and ft(i,j)
0 t⫺1 is the conditional variance of the forecast error ht0 t⫺1 based on
the information up to time t ⫺ 1 given st⫺1 ⫽ i and st ⫽ j. The uncondi-
tional mean and variance of dt are respectively given by 0 and sn2兾(1 ⫺ f2),
which are used as initial values d̂0 0 0 and M̂0 0 0 of the Kalman filter and
estimated as unknown parameters via maximum likelihood.
The second step of Kim’s filter is to calculate P(st 0 ct⫺1 ) and P(st 0 ct )
for i, j ⫽ 1, 2. These probabilities are required for approximation in the
third step of Kim’s filter and are calculated via the Hamilton filter with
the following steps:
Calculate P(st 0 ct⫺1 ) :

P(st ⫽ j, st⫺1 ⫽ i 0 ct⫺1 ) ⫽ P(st ⫽ j 0 st⫺1 ⫽ i)P(st⫺1 ⫽ i 0 ct⫺1 ) (14.1)

2
P(st ⫽ j 0ct⫺1 ) ⫽ a P(st ⫽ j 0 st⫺1 ⫽ i)P(st⫺1 ⫽ i 0 ct⫺1 ) (14.2)
i⫽1

Calculate f(Rs,t 0 ct⫺1 ) :

f(Rs,t 0 st ⫽ j, st⫺1 ⫽ i, ct⫺1 ) ⫽ (2p)⫺ 2 0 ft(i,j)

| t⫺1 0 b (14.3)
1
⫺2 1 1 (i,j)⬘ (i,j)⫺1 (i,j)
expa⫺ h f h
2 t |t⫺1 t | t⫺1 t | t⫺1
2 2
f(Rs,t 0 ct⫺1 ) ⫽ a a f(Rs,t 0 st ⫽ j, st⫺1 ⫽ i, ct⫺1 ) P(st ⫽ j, st⫺1 ⫽ i 0 ct⫺1 ) (14.4)
j⫽1 i⫽1

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 Dynamic Futures Hedging 111

Update P(st | ct ) :
f(Rs,t, st ⫽ j, st⫺1 ⫽ i 0 ct⫺1 )
P(st ⫽ j, st⫺1 ⫽ i | ct ) ⫽
f(Rs,t 0 ct⫺1 )
f(Rs,t 0 st ⫽ j, st⫺1 ⫽ i, ct⫺1 )P(st ⫽ j, st⫺1 ⫽ i 0 ct⫺1 )
⫽ (14.5)
f(Rs,t 0 ct⫺1 )
2
P(st ⫽ j 0 ct ) ⫽ a P(st ⫽ j, st⫺1 ⫽ i 0 ct ) (14.6)
i⫽1

where ct and ct⫺1 refer to the information available at time t and t ⫺ 1,

respectively.
To initiate the Hamilton filter the steady-state probabilities of st are
set as
1⫺p
P(s0 ⫽ 1 0 c0 ) ⫽
2⫺p⫺q
(15)
1⫺q
P(s0 ⫽ 2 0 c0 ) ⫽
2⫺p⫺q
where p and q are defined in Equation (11). Each iteration of the
Kalman filter produces a twofold increase in the number of cases to con-
sider. To make the evolution of the process tractable, the third step of
Kim’s filter is to mitigate parameter proliferation by collapsing (13.5) and
(13.6) based on conditional expectations. In particular, d̂ tj 0 t and Mjt 0 t are
defined by

a i⫽1P(st⫺1 ⫽ i, st ⫽ j 0 ct )d̂t0t
2 (i,j)

P(st ⫽ j 0 ct )
d̂tj0 t ⫽ (16)

and

a i⫽1P(st⫺1 ⫽ i, st ⫽ j 0 ct )[Mt|t ⫹ (d̂t|t ⫺ d̂t|t )(d̂t|t ⫺ d̂t|t )⬘]

2 (i,j) j (i,j) j (i,j)

Mtj0 t ⫽
P(st ⫽ j 0 ct )
(17)

The unknown parameters, p0, q0, ast, s2e,st, b, f, and sn2 can be esti-
mated by maximizing the following log-likelihood function with respect
to the unknown parameters:
T
LL ⫽ a log( f(Rs,t 0 ct⫺1 )) (18)
t⫽1

Journal of Futures Markets DOI: 10.1002/fut

112 Lee, Yoder, Mittelhammer, and McCluskey

where T is the total number of observations and f(Rs,t 0 ct⫺1 ) is defined in

ˆ
Equation (14.4). With the estimated latent variable d̂tj0 t and b in hand,
the estimates of b j at time t can be recovered as follows:

b̂tj0 t ⫽ Ê[bt 0 st⫺1 ⫽ i, st ⫽ j, ct] ⫽ d̂tj0 t ⫹ b

ˆ
(19)
and the estimates of expected optimal hedge ratios are

b̂ *t 0 t ⫽ b̂ t 0 tP(st ⫽ 1 0 ct ) ⫹ b̂t 0 tP(st ⫽ 2 0 ct )

1 2
(20)

Out-of-sample one-step-ahead hedge ratios can be calculated as the

weighted average of one-step-ahead forecasts of bi at time t ⫺ 1 for i ⫽ 1, 2.
The one-step-ahead forecasts of b ti at time t ⫺ 1 are defined as
b̂ it 0 t⫺1 ⫽ Ê[bt 0 st⫺1 ⫽ i, ct⫺1] ⫽ d̂ti 0 t⫺1 ⫹ b
ˆ
(21)

The one-step-ahead forecasts of hedge ratios can then be calculated as

t 0 t⫺1 ⫽ b̂t 0 t⫺1P(st⫺1 ⫽ 1 0 ct⫺1 ) ⫹ b̂t 0 t⫺1P(st⫺1 ⫽ 2 0 c t⫺1 )

1 2
b̂* (22)

MEASURING HEDGING PERFORMANCE

The hedging performance is typically evaluated based on the percentage
variance reduction of the hedged portfolio relative to the unhedged
position. The variance of the estimated optimal hedged portfolio can be
characterized as
Var(Rs,t ⫺ b̂*t Rf,t ) (23)
where the b̂*t ’s are the estimated optimal hedge ratios derived from the
various estimation models.
Because frequent rebalancing of the hedged portfolio is required
with the dynamic hedging methods, they are more costly to implement.
To evaluate the economic significance of these dynamic hedging methods,
investor preferences need to be accounted for. Suppose the investor
faces the following mean-variance expected utility function:
EtU(xt⫹1 ) ⫽ Et (xt⫹1 ) ⫺ ks2t (xt⫹1 ) (24)
where k is the degree of risk aversion and xt⫹1 is the return from the hedged
portfolio. A dynamic hedging method is considered to be superior to a static
hedging method if it has higher expected utility net of transaction costs.
In addition to providing a measure of risk reduction and economic
significance, the statistical significance of the variance reduction provid-
ed by these models is also tested. Although numerous articles have
provided point estimate comparisons of performance among sets of

Journal of Futures Markets DOI: 10.1002/fut

 Dynamic Futures Hedging 113

alternative hedging strategies (for example, Alizadeh & Nomikos, 2004,

Gagnon & Lypny, 1995), as far as is known, only Byström (2003) has
examined the statistical significance of hedging-performance compar-
isons. Byström (2003) uses bootstrap methods in a relatively conventional
way to estimate sampling distributions for difference among variance
estimates, thus providing a basis for testing the significance of the
differences.5 In econometric analysis, however, it is well known that data-
snooping bias may result when a given sample of data is reused by one or
more researchers for model selection. This data-snooping process may
lead to an excessive likelihood of rejecting the null hypothesis of no supe-
riority of one model over a benchmark when no superiority is true (a bias
toward Type I errors). An attempt is made to account for this potential
data-snooping bias by applying the bootstrap version of White’s reality
check for data snooping (Sullivan, Timmermann, & White, 1999; White,
2000). White’s reality check is used for testing the null hypothesis that the
best model encountered in a specification search has no predictive
superiority over a given benchmark model. This article is, to the authors’
knowledge, the first to apply this test to compare hedging performance.
The innovation of White’s method is that it incorporates information
provided by estimated alternative models into a statistical assessment of
the best-performing model relative to a benchmark. White’s reality check
is based on the following l ⫻ 1 performance statistic:
T
f ⫽ n⫺1 a f̂t⫹1 (25)
t⫽R

where l is the number of alternative models considered (which is equal

to 5 in this study), n is the number of prediction periods indexed from
R to T so that n ⫽ T ⫺ R ⫹ 1, f̂t⫹1 is the observed performance measure
for period t ⫹ 1, the kth element of which is defined as

fˆk,t⫹1 ⫽ ⫺(Rs,t ⫺ b̂k,tRf,t ) 2 ⫹ (Rs,t ⫺ b̂BM,t Rf,t ) 2 (26)

where b̂BM,t is the estimate of b from the benchmark, and

b̂k,t, 5k ⫽ 1, p , l is the one-step-ahead prediction of b from alternative
models at time t. The null hypothesis is that the performance of the best
hedging model is no better than the benchmark:
H0 : max [E( f*k )] ⱕ 0 (27)
k⫽1,p,l

where f*k is the true performance value for each model applied to the
data. Following White (2000), the test is based on the stationary
5
Byström (2003) finds that no hedge method differs in a statistical way from the unhedged spot
position, and no hedge method significantly differs from any other hedge method.

Journal of Futures Markets DOI: 10.1002/fut

114 Lee, Yoder, Mittelhammer, and McCluskey

bootstrap resampling method of Politis and Romano (1994), applicable

to time-series data in which pseudo-time series are generated by resam-
pling blocks of random size and the length of each block has a geometric
distribution. This resampling procedure allows an approximation
of quantiles of f (Equation 25) as the vector of estimates for E( f*k),
k ⫽ 1, . . . , l.

DATA DESCRIPTION AND

EMPIRICAL RESULTS
The models are applied to weekly data on aluminum and lead futures
contracts traded on the London Metal Exchange for the period
01/06/1993–07/28/2004. The spot and futures data are Wednesday’s
closing price. Tuesday’s closing price is used when a holiday occurs
on Wednesday. The data for the period 01/06/1993–07/30/2003 are
used for in-sample estimation and the data for the period
08/06/2003–07/28/2004 are used for out-of-sample estimation. The spot
and futures (geometric) returns are calculated as the differences in the
logarithms of prices multiplied by 100. Summary statistics for spot and
futures prices are shown in Tables II and III.
Parameter estimates from all alternative models are presented in
Tables IV and V for aluminum and lead futures contracts, respectively.
The parameters are estimated by maximizing the log-likelihood function
in Equation (18) with the use of the numerical constrained optimization
(CO) procedure in GAUSS (version 6.0). Tables VI and VII show the
in- and out-of-sample hedging effectiveness of alternative models for
aluminum and lead futures contracts, respectively.
For the aluminum futures contract, RCAR has the lowest in-sample
hedged portfolio variance, with a 99.14% in-sample variance reduction

TABLE II
Summary Statistics for Spot and Futures Prices of Aluminum Contract Traded
in the London Metal Exchange

In sample Out of sample

Log level % return Log level % return

Spot Futures Spot Futures Spot Futures Spot Futures

Mean 7.2734 7.2874 0.0366 0.0293 7.3700 7.3749 0.2433 0.2996

SD 0.1343 0.1326 2.2560 2.0762 0.0673 0.0708 2.2024 2.1015
Skewness 0.0112 0.0339 ⫺0.1310 ⫺0.1264 ⫺0.4097 ⫺0.4596 0.0092 0.1039
Kurtosis ⫺0.0882 ⫺0.0735 1.9775 2.3286 ⫺1.0602 ⫺1.0842 0.1435 0.1753

Journal of Futures Markets DOI: 10.1002/fut

 Dynamic Futures Hedging 115

TABLE III
Summary Statistics for Spot and Futures Prices of Lead Contract Traded
in the London Metal Exchange

In sample Out of sample

Log level % return Log level % return

Spot Futures Spot Futures Spot Futures Spot Futures

Mean 6.2625 6.2802 0.0003 0.0002 6.5802 6.5565 0.0132 0.0109

SD 0.1939 0.1856 0.0295 0.0253 0.2153 0.1918 0.0457 0.0406
Skewness 0.6421 0.6255 ⫺0.0455 ⫺0.1255 ⫺0.3985 ⫺0.5095 ⫺0.1432 0.1621
Kurtosis ⫺0.3225 ⫺0.4570 1.5625 1.6024 ⫺0.9839 ⫺0.9229 0.1242 0.5505

compared to the variance of the unhedged position, followed by BEKK-

GARCH, with 96.24% in-sample variance reduction. RCARRS has a
95.91% in-sample variance reduction and is better than CC-GARCH, MRS,
and OLS, with 95.71%, 95.89%, and 95.72% variance reduction, respec-
tively.6 For lead futures, RCARRS is inferior to both RCAR and MRS (refer
to tables for variance-reduction estimates). RCARRS, however, has better
in-sample performance than OLS, CC-GARCH, and BEKK-GARCH.
Active hedgers are likely to be more concerned about future
hedging performance; so out-of-sample tests are useful for model com-
parison. Overall, RCARRS is found to have better out-of-sample per-
formance than RCAR and MRS. For the aluminum futures contract,
RCARRS has a 96.17% out-of-sample variance reduction and is superi-
or to both RCAR and MRS.7 In comparison to the GARCH models
examined, RCARRS point estimates suggest it to be superior to CC-
GARCH but inferior to BEKK-GARCH. For the lead futures contract,
RCARRS outperforms both RCAR and MRS out of sample. RCARRS
has an 89.20% out-of-sample variance reduction and outperforms all
6
It might seem odd that RCAR has better in-sample performance than the less-restrictive RCARRS
model. Maximum-likelihood (ML) approach provides the minimum-variance parameter estimator
among consistent estimators. However, ML may not minimize the variance of the hedging portfolio.
Therefore, although a less restrictive model (RCARRS) has a higher likelihood value and smaller
parameter variance, it might still provide a higher in-sample hedging portfolio variance than that of
the model nested within it (RCAR).
7
A variant of RCARRS in which the transition Equation (10.2) is subject to regime switching
is also investigated. The equation can be specified as (bt ⫺ b) ⫽ fst (bt⫺1 ⫺ b) ⫹ nt,st; where
nt,st ⬃ iid(0, s2n,st ). Simulation results show that in-sample variance reduction for aluminum is
99.05% and out-of-sample variance reduction is 95.72%. This is consistent with previous research
finding that nonlinear models such as regime switching models have superior in-sample but inferior
out-of-sample forecasting performance (Brooks, 1997; Dacco & Satchell, 1999). A comparison of
these numbers to those in Table VI shows that when only the measurement equation is allowed to
be subject to regime switching, the out-of-sample forecasting performance is improved at the cost of
in-sample performance.

Journal of Futures Markets DOI: 10.1002/fut

116 Lee, Yoder, Mittelhammer, and McCluskey

TABLE IV
Estimates of Unknown Parameters of Alternative Models for Aluminum Futures
Contract. Sample Period: January 6, 1993 to July 30, 2003

RCARRS MRS RCAR CC-GARCH BEKK-GARCH

p0 1.7850 ms ⫺0.1168 ms ⫺0.0238

(0.4299)a (0.0777) (0.0374)
q0 3.5419 mf ⫺0.1194 mf ⫺0.0186
(0.3591) (0.0719) (0.0358)
a1 0.0096 ⫺0.0188 0.0031 r 0.9817 gss 1.7816
(0.0111) (0.1279) (0.0166) (0.0015) (0.1304)
a2 ⫺0.0075 0.0145 gs 0.4212 gfs 1.7580
(0.0964) (0.0114) (0.1080) (0.1183)
b1 1.1689 as 0.1119 gff 0.0000
(0.0612) (0.0197) (0.0297)
b2 1.0451 bs 0.8142 ass 1.7046
(0.0054) (0.0281) (0.2847)
ss1 0.2110 1.0726 0.2824 gf 0.2921 asf 0.9579
(0.0101) (0.1131) (0.0156) (0.0851) (0.2693)
ss2 1.0411 0.2176 af 0.0764 afs ⫺1.6269
(0.0979) (0.0122) (0.0149) (0.2984)
sn 0.0123 0.1965 bf 0.8585 aff ⫺0.8698
(0.0063) (0.0135) (0.0259) (0.2831)
f 0.9282 0.2202 bss 0.5052
(0.0648) (0.0810) (0.0939)
b 1.0551 1.0791 bsf ⫺0.2352
(0.0095) (0.0144) (0.0933)
f01 0.2541 bfs 0.0210
(2.3083) (0.0521)
f11 0.2760 bff 0.7377
(1.4882) (0.0611)
f02 ⫺0.9640
(3.0493)
f12 ⫺2.6858
(0.8546)

Log-Lb ⫺135.06 ⫺133.54 ⫺298.25 ⫺1496.17 ⫺1316.82

a
Figures in parentheses are standard errors.
b
Log-L stands for log likelihood.

other dynamic hedging models, including BEKK-GARCH.8 However,

the static OLS point estimate performs the best of all out-of-sample for
the lead data.9
8
Because of the structure of the different models, it is speculated that BEKK-GARCH will tend to
outperform RCARRS when volatility changes are relatively smooth and continuous, whereas
RCARRS might outperform BEKK-GARCH when the hedge ratio is subject to sharper fluctuations,
a tendency to a long-run equilibrium value, or is subject to regime switches.
9
Byström (2003) reports similar results that OLS outperforms more elaborate dynamic hedging
models for electricity futures on the Nordic Power Exchange.

Journal of Futures Markets DOI: 10.1002/fut

 Dynamic Futures Hedging 117

TABLE V
Estimates of Unknown Parameters of Alternative Models for Lead Futures Contract.
Sample Period: January 6, 1993 to July 30, 2003

RCARRS MRS RCAR CC-GARCH BEKK-GARCH

p0 4.1367 ms ⫺0.0521 ms ⫺0.0714

(0.5147)a (0.0995) (0.1220)
q0 1.3655 mf ⫺0.0469 mf ⫺0.0763
(0.5415) (0.0852) (0.1105)
a1 0.0832 ⫺0.0182 ⫺0.0008 r 0.9614 gss 0.7235
(0.3870) (0.0798) (0.0296) (0.0032) (0.2257)
a2 0.0000 0.0005 gs 6.3883 gfs 0.3359
(0.0253) (0.0249) (0.9534) (0.1526)
b1 1.2623 as 0.2246 gff 0.0915
(0.0616) (0.0372) (0.2751)
b2 1.0676 bs 0.0564 ass 0.5895
(0.0100) (0.1054) (0.0872)
ss1 2.6038 1.6133 0.8124 gf 4.6185 asf 0.0181
(0.3718) (0.1462) (0.0496) (0.8866) (0.0598)
ss2 0.5789 0.4213 af 0.1807 afs ⫺0.4237
(0.0231) (0.0364) (0.0393) (0.1083)
sn 0.0056 0.1442 bf 0.1067 aff 0.1155
(0.0038) (0.0551) (0.1363) (0.0821)
f bss 0.6122
(0.0858)
b 0.9910 0.4636 bsf ⫺0.0406
(0.0127) (0.1864) (0.0402)
f01 bfs 0.3816
(0.0899)
f11 1.1058 1.1238 bff 1.0259
(0.0266) (0.0204) (0.0432)
f02 ⫺0.7149
(2.0019)
f12 0.7575
(0.9223)

Log-Lb ⫺565.34 ⫺571.94 ⫺703.18 ⫺1941.28 ⫺1878.38

a
Figures in parentheses are standard errors.
b
Log-L stands for log likelihood.

Figures 1–6 exhibit various characteristics of the alternative esti-

mated models based on the aluminum data. Figure 1 compares the
hedge ratios of RCARRS, MRS, and OLS. The MRS hedge ratios have a
lower bound of 1.05, which is the MRS estimate of b2 and an upper
bound of 1.17, which is the MRS estimate of b1. The resulting time-varying
MRS hedge ratio is then the weighted average of estimated b1 and b2,
weighted according to the time-varying regime probability. Because the

Journal of Futures Markets DOI: 10.1002/fut

 TABLE VI
In- and Out-of-Sample Hedging Effectiveness of Alternative Models for Aluminum Futures Contracta

In sample Out of sample

Variance Utility Variance Utility

reduction Weekly improvement reduction Weekly improvement
Variance b (%)c utility d wrt OLS e Variance (%) utility wrt OLS

Unhedged 5.11999 ⫺20.4800 4.75823 ⫺19.0329

OLS 0.21919 95.7190% ⫺0.8767 0.19168 95.9717% ⫺0.7667
RCARRS 0.20962 95.9059% ⫺0.8385 0.0382 0.18223 96.1701% ⫺0.7289 0.0378
MRS 0.21025 95.8935% ⫺0.8410 0.0357 0.19754 95.8485% ⫺0.7901 ⫺0.0234
RCAR 0.04400 99.1405% ⫺0.1760 0.7007 0.20505 95.6907% ⫺0.8202 ⫺0.0535
CC-GARCH 0.21969 95.7092% ⫺0.8788 ⫺0.0021 0.18345 96.1447% ⫺0.7338 0.0329
BEKK-GARCH 0.19264 96.2375% ⫺0.7706 0.1061 0.17116 96.4029% ⫺0.6846 0.0821

a
The in-sample data period is from January 6, 1993 to July 30, 2003 and the out-of-sample data period is from August 8, 2003 to July 28, 2004.
b
Variance stands for the variance of the hedged portfolio calculated based on Equation (23).
c
Percentage variance reductions are calculated as the differences of variance of unhedged position and estimated variance of alterative models over variance of unhedged position
multiplied by 100.
d
Weekly utility is the average weekly utility calculated based on Equation (24) with assumptions of a coefficient of risk aversion of 4 and a zero expected return from the hedged portfolio.
e
Utility improvement with respect to OLS is the weekly utility gain/loss by using alternative time-varying hedging strategies relative to the static OLS strategy before taking account of
transaction costs.
 TABLE VII
In- and Out-of-Sample Hedging Effectiveness of Alternative Models for Lead Futures Contracta

In sample Out of sample

Variance Utility Variance Utility

reduction Weekly improvement reduction Weekly improvement
Varianceb (%)c utility d wrt OLSe Variance (%) utility wrt OLS

Unhedged 8.73888 ⫺34.9555 20.67278 ⫺82.6911

OLS 0.81253 90.7022% ⫺3.2501 2.21518 89.2846% ⫺8.8607
RCARRS 0.80431 90.7962% ⫺3.2172 0.0329 2.23264 89.2001% ⫺8.9306 ⫺0.0699
MRS 0.80372 90.8029% ⫺3.2149 0.0352 2.51520 87.8333% ⫺10.0608 ⫺1.2001
RCAR 0.57373 93.4347% ⫺2.2949 0.9552 2.23870 89.1708% ⫺8.9548 ⫺0.0941
CC-GARCH 0.80879 90.7450% ⫺3.2351 0.0150 2.38984 88.4397% ⫺9.5594 ⫺0.6987
BEKK-GARCH 0.80577 90.7795% ⫺3.2231 0.0270 2.32145 88.7705% ⫺9.2858 ⫺0.4251

a
The in-sample data period is from January 6, 1993 to July 30, 2003 and the out-of-sample data period is from August 8, 2003 to July 28, 2004.
b
Variance stands for the variance of the hedged portfolio calculated based on Equation (23).
c
Percentage variance reductions are calculated as the differences of variance of unhedged position and estimated variance of alterative models over variance of unhedged position
multiplied by 100.
d
Weekly utility is the average weekly utility calculated based on Equation (24) with assumptions of a coefficient of risk aversion of 4 and a zero expected return from the hedged portfolio.
e
Utility improvement with respect to OLS is the weekly utility gain/loss by using alternative time-varying hedging strategies relative to the static OLS strategy before taking account of
transaction costs.
120 Lee, Yoder, Mittelhammer, and McCluskey

FIGURE 1
RCARRS, MRS, and OLS hedge ratios for aluminum futures contract.

estimated probability of being in a high-variance state is below unity for

the entire sample period, the estimated MRS hedge ratios do not reach the
upper bound. The hedge ratio in the RCARRS has a tendency toward
the estimated equilibrium value b ⫽ 1.06 with a mean reversion rate of
f ⫽ 0.93. Figures 2 and 3 show RCARRS and MRS estimates of the
probability of being in the high-variance state, respectively. In contrast to
the MRS model, there is no specific upper or lower bound on hedge
ratios in RCARRS.
Figure 4 compares RCARRS and RCAR hedge ratios for aluminum.
The standard deviation of the disturbance term in the transition equation
(sn ) of RCAR (0.197) is around 16 times of that of RCARRS (0.012),
implying that the time-varying coefficient of RCAR is allowed to vary more
freely than that of RCARRS.10 A more flexible time-varying coefficient
captures in-sample variation well but can be too volatile for good out-of-
sample forecasting. This explains why RCAR has excellent in-sample

10
This difference may be because the parameters in the measurement equation are state dependent
in RCARRS but not in RCAR. This allows the RCARRS measurement equation to absorb more of
the variation in the system and leave less variation to be absorbed by the transition equation.

Journal of Futures Markets DOI: 10.1002/fut

 FIGURE 2
Regime probability of high-variance state estimated from RCARRS for
aluminum futures contract.

FIGURE 3
Regime probability of high-variance state estimated from MRS for aluminum
futures contract.

Journal of Futures Markets DOI: 10.1002/fut

122 Lee, Yoder, Mittelhammer, and McCluskey

FIGURE 4
RCARRS and RCAR hedge ratios for aluminum futures contract.

performance but poor out-of-sample hedging effectiveness.11 Figures 5

and 6 show the CC-GARCH and BEKK-GARCH estimates of hedge
ratios, respectively. CC-GARCH and BEKK-GARCH hedge ratios have
volatility patterns similar to that of RCAR, but are relatively less volatile.
To compare the economic value of these dynamic hedging methods,
the utility improvement of these methods relative to OLS is measured.
As in other empirical studies in the literature (Alizadeh & Nomikos,
2004; Kroner & Sultan, 1993; Lafuente & Novales, 2003; Park &
Switzer, 1995), it is assumed that an investor has an expected utility
function given by Equation (4) with degree of risk aversion k ⫽ 4 and
zero expected return to the hedged portfolio. The utility improvements
from alternative dynamic hedging models compared to the static OLS
hedging method for aluminum futures contracts are shown in Table VI.
11
When the time-varying coefficient can vary more freely from period to period, the measurement
error can be reduced. A reduction in the variance of measurement error implies a reduction in the
variance of the hedging portfolio. To see this, from Equation (3), the measurement error can be
expressed as et ⫽ Rs,t ⫺ a ⫺ btRf,t, with variance E[e2t ] ⫽ Var(et), which is also the variance of the
hedged portfolio. With a larger sn, the measurement-error variance (and hence the hedging portfo-
lio variance) will be relatively smaller. Thus, RCAR (with a large sn) has very good in-sample
performance.

Journal of Futures Markets DOI: 10.1002/fut

 FIGURE 5
RCARRS, CC-GARCH, and OLS hedge ratios for aluminum contract.

FIGURE 6
RCARRS, BEKK-GARCH, and OLS hedge ratios for aluminum
futures contract.

Journal of Futures Markets DOI: 10.1002/fut

124 Lee, Yoder, Mittelhammer, and McCluskey

The average weekly in-sample variance of the returns from hedge

portfolio for OLS and RCARRS hedging are 0.21919 and 0.20962,
respectively. Based on Equation (24), if an investor uses the OLS
method for hedging, he or she obtains an average weekly utility of
U(xt⫹1) ⫽ ⫺4(0.21919) ⫽ ⫺0.8767. With RCARRS, the investor obtains
an average weekly utility of U(xt⫹1) ⫽ ⫺4(0.20962) ⫽ ⫺0.8385. Because
a time-varying hedging strategy requires frequent portfolio rebalancing,
the hedger’s net benefit from using RCARRS hedging over OLS hedging
is 0.0382 ⫺ y, where y represents the transaction cost from portfolio
rebalancing. This implies that if y ⬍ 3.82%, the RCARRS hedging
strategy is preferred to the OLS hedging strategy. Because the typical
round-trip transaction cost is around 0.02% to 0.04%, an investor with
mean-variance expected utility function and k ⫽ 4 would benefit from
using the RCARRS hedging method, even after transaction costs are
taken into account.12 The utility improvements from alternative dynamic
hedging models over OLS hedging method for the lead futures contract
are shown in Table VII. Because none of the point estimates of the out-
of-sample variance reductions estimated from dynamic hedging models
outperforms the OLS method, the out-of-sample utility improvement
with respect to OLS are all negative.
To test the statistical significance of the performance of these
dynamic hedging models, White’s reality check is performed, as summa-
rized previously, with the use of the worst performer for each respective
data series as the benchmark model defined by least variance
reduction.13 For the aluminum data, RCAR is the worst out-of-sample
performance. The null hypothesis of no improvement over RCAR is
rejected for BEKK-GARCH, given all other alternatives including
RCARRS (p value ⫽ 0.000). To focus more closely on the state-space
models of interest in this article, White’s test is also performed with
BEKK-GARCH omitted, and RCARRS is treated as “best” among this
subset of alternatives. The null hypothesis of no improvement over OLS
is again rejected (p value ⫽ 0.003).
For the lead contract data, MRS is the worst performer, OLS is the
best performer, and again, RCARRS is second best. For OLS, the reality
check p value is 0.095, so there is rejection at the 10% level but not at

12
The price of one aluminum contract with the price level of $1,800 is $45,000 ($1,800 *
25 tonnes/contract). For a typical round-trip commission of $10–$20, the transaction costs will be
around 0.02% to 0.04%.
13
To apply the stationary bootstrap method of Politis and Romano (1994), the smoothing parameter
q is set to 0.5 and resampling is done 1000 times for each application.

Journal of Futures Markets DOI: 10.1002/fut

 Dynamic Futures Hedging 125

the 5% level. For RCARRS, the null hypothesis of no superiority over

MRS at conventional test sizes is not rejected (p value ⫽ 0.151).

CONCLUSION
The random coefficient autoregressive regime switching (RCARRS) model
is proposed as an alternative for estimating time-varying minimum-
variance hedge ratios. RCARRS contains elements of the random coeffi-
cient autoregressive model of Bera et al. (1997) and the Markov regime
switching model of Alizadeh and Nomikos (2004), but differs from either
of these in a number of ways. First, RCARRS accounts for both the state of
market volatility and the equilibrium time path of optimal hedge ratios.
Second, the hedge ratio estimated from RCARRS is time varying even
though conditional market regime probabilities are constant, whereas
the hedge ratio estimated from MRS is time-varying because market
regime probabilities vary as a function of a time-varying lagged basis. The
hedge ratio estimated from MRS is a constant when the regime probabili-
ties are constant. Third, MRS estimates of hedge ratios are restricted to lie
within a given range. The RCARRS estimates of hedge ratios, however, are
allowed to vary freely without upper- and lower-bound restrictions. To esti-
mate the time-varying minimum-variance hedge ratio, Kim’s filter is
applied along with a transformation of the latent hedge ratio to arrive at a
state-space representation of the model.
RCARRS and a set of well-known alternative models are applied to
two data series: aluminum and lead futures contract data. Based on
point estimates of out-of-sample portfolio variance reduction for the alu-
minum contracts, it is found that RCARRS outperforms both MRS and
RCAR. The in-sample hedging performance of RCARRS is superior to
that of MRS, but inferior to RCAR. RCARRS is superior to CC-GARCH
but inferior to BEKK-GARCH both in and out of sample. For the lead
data, RCARRS has better out-of-sample performance than all other
dynamic hedging models considered, but none of these dynamic hedging
models outperforms OLS out of sample. White’s reality check is also per-
formed to test the hypothesis that the best-performing dynamic hedging
model for each data set has no predictive superiority over the respective
poorest performers. For the aluminum data, the null hypothesis of no
improvement over the benchmark is rejected for both BEKK-GARCH and
RCARRS. For lead futures contracts, the null hypothesis that OLS (the
best nominal performer) or RCARRS is better than the worst performer,
MRS cannot be rejected. Although numerous articles have provided point
estimate comparisons of performance among sets of alternative hedging

Journal of Futures Markets DOI: 10.1002/fut

126 Lee, Yoder, Mittelhammer, and McCluskey

strategies (for example, Alizadeh & Nomikos, 2004, Gagnon & Lypny,
1995), as far as is known only Byström (2003) has examined the statistical
significance of hedging-performance comparisons, and none have
attempted to account for data-snooping bias. Thus, in addition to the
introduction of RCARRS as a tractable alternative hedging model with
promising predictive performance, this article is the first to examine the
statistical significance of hedging-strategy performance by applying
White’s data-snooping reality check to hedging models. Future applica-
tions to data derived from other hedging contexts should be pursued to
further explore the robustness of RCARRS superior hedging performance.

APPENDIX
Bivariate GARCH models are widely used in studying the time-varying
minimum variance hedge ratio. The bivariate GARCH models used in
this study are specified below, where two specifications of the conditional
covariance matrix, BEKK and constant correlation, are considered in
this research.
Let Rs and Rf be the returns on the spot and futures, respectively.
The bivariate GARCH model can be specified as
Rs,t ⫽ ms ⫹ es,t (A.1)
Rf,t ⫽ mf ⫹ ef,t (A.2)

et 0 ct⫺1 ⫽ c d ` ct⫺1 ⬃ BN(0, Ht )

es,t
(A.3)
ef,t
where es,t and ef,t are residuals, ct⫺1 refers to the information available
at time t ⫺ 1, BN denotes the bivariate normal, and Ht is a time-varying
2 ⫻ 2 positive-definite conditional covariance matrix.
Two parametrizations of the conditional variance–covariance matrix
are studied in this research. The first one is the BEKK specification
(Engle & Kroner, 1995; Gagnon & Lypny, 1995), which is specified in
Equation (A.4):

h2s,t
Ht ⫽ c d
hsf,t
hsf,t h2f,t

gss 0 gss 0 ⬘ a asf ⬘ e2s,t⫺1

⫽ c dc d ⫹ c ss d c dc d
es,t⫺1ef,t⫺1 ass asf
gfs gff gfs gff afs aff es,t⫺1ef,t⫺1 e2f,t⫺1 afs aff
bss bsf ⬘ h2s,t⫺1
⫹ c d c dc d
hsf,t⫺1 bss bsf
(A.4)
bfs bff hsf,t⫺1 h2f,t⫺1 bfs bff

Journal of Futures Markets DOI: 10.1002/fut

 Dynamic Futures Hedging 127

2 2
where hsf,t is a conditional covariance, and hs,t and hf,t are conditional
variances. The parametrization of the conditional variance–covariance
matrix of constant-correlation GARCH (Bera et al., 1997; Bollerslev,
1990; Kroner & Sultan, 1993; Lien, Tse, & Tsui, 2002, Miffre, 2004;
Park & Switzer, 1995) is shown in Equation (A.5).
h2s,t
Ht ⫽ c 2 d ⫽ c dc dc d
hsf,t hs,t 0 1 r hs,t 0
(A.5)
hsf,t hf,t 0 hf,t r 1 0 hf,t
where r is the time-invariant correlation coefficient, and the conditional
2
variances hs,t and h2f,t are assumed to be a standard univariate GARCH
process as follows:

h2s,t ⫽ gs ⫹ ase2s,t⫺1 ⫹ bsh2s,t⫺1 (A.6)

h2f,t ⫽ gf ⫹ af e f,t⫺1
2
⫹ bf h2f,t⫺1 (A.7)

The parameters to estimate are u ⫽ {rss, rff, rfs, ass, asf, afs, aff, bss, bfs,
bsf, bff, ms, mf } and u ⫽ {mi , gi , ai , bi , r} for i ⫽ {s, f } for BEKK and
constant-correlation GARCH model, respectively, which can be estimated
by maximizing the following log-likelihood function with respect to the
unknown parameters:
1 T 1 T
L(u) ⫽ ⫺T log (2p) ⫺ a log 0Ht (u) 0 ⫺ ⫺1
a et (u)⬘Ht (u)et (u) (A.8)
2 i⫽1 2 i⫽1
where T is the total number of observations.
The time-varying hedge ratios can be expressed with the variances
and covariance estimates from (A.4) and (A.5):

bˆ*t ⫽ ĥsf,t兾ĥ2f,t (A.9)

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